FIRE 437 Review Guide for Final Examination

Please note that this guide only covers new material since Midterm 2. You should study
earlier review materials and your first two midtermss, as the final is cumulative.
1.
While liquidity risk was covered in the second midterm, it might be re-emphasized on the
final in the context of regulation of financial services companies. Remember that most bank
failures are triggered by liquidity issues, not capital deficiency. Be able to discuss the reasons
bank runs are feared by regulators, politicians and banks. Based on what you know about
bank balance sheets, could any bank survive a severe bank run
2.
Be able to define Sovereign risk. How does it differ from country risk and currency
risk? Remember that in our class discussion, I disagreed with the author. Sovereign risk is
properly thought of as the credit risk assumed when investing in debt securities issued by
nations. This risk is somewhat different from normal credit risk in that political calculations are
involved in the pay/dont pay decision. Also, countries do not go bankrupt in the normal
sense, so other means of resolving sovereign defaults are used. Be prepared to discuss them.
Sovereign risk-- the risk that a foreign central bank will alter its foreign-exchange regulations
thereby significantly reducing or completely nulling the value of foreign-exchange contracts
Country risk-- A collection of risks associated with investing in a foreign country. These risks
include political risk, exchange rate risk, economic risk, sovereign risk and transfer risk, which is
the risk of capital being locked up or frozen by government action. Country risk varies from one
country to the next. Some countries have high enough risk to discourage much foreign
investment
Currency risk--A collection of risks associated with investing in a foreign country. These risks
include political risk, exchange rate risk, economic risk, sovereign risk and transfer risk, which is
the risk of capital being locked up or frozen by government action. Country risk varies from one
country to the next. Some countries have high enough risk to discourage much foreign
investment
3.
Be able to discuss the link between deposit insurance systems and bank regulation.
Also, be able to identify the deposit insurance authority in the US banking industry. Remember
that credit unions deposits are insured by the NCUA (which is also the primary federal regulator
of credit unions).
Deposit insurance systems protect bank depositors from loses caused by a banks
inability to pay its debts when due; protects financial stability. Because banking
institution failures have the potential to trigger a broad spectrum of harmful events,
including economic recessions, policy makers maintain deposit insurance to
projected depositors and to give them comfort that their funds are not at risk. FDICFederal Deposit Insurance Corporation.
4.
Be able to discuss the importance of bank capital as a tool for bank regulators. Be able
to explain what the primary objective of safety and soundness regulation of banks is.
5.
Bank regulators now focus strongly on common equity as the primary definition of
capital. Previously, banks were able to use long term debt and redeemable preferred stock as
50% of their regulatory capital. Explain how the 2008 credit crisis led to this change as is
illustrated in the new Basel III agreement.
Seeks to improve the banking sector's ability to deal with financial and economic stress,
improve risk management and strengthen the banks' transparency. A focus of Basel III is to
foster greater resilience at the individual bank level in order to reduce the risk of system wide
shocks.

6.
Be able to show reasonable familiarity with FDICIA, Gramm Leach Bliley and Dodd
Frank as they relate to regulation of US Banks.
FDICIA--The Act mandated a least-cost resolution method and prompt resolution approach to
problem and failing banks and ordered the creation of a risk-based deposit insurance
assessment scheme.. FDICIA created new supervisory and regulatory examination standards
and put forth new capital requirements for banks. It also expanded prohibitions against insider
activities and created new Truth in Savings provisions.
Gramm Leach Bliley-- Repeals last vestiges of the Glass Steagall Act of 1933. Modifies portions
of the Bank Holding Company Act to allow affiliations between banks and insurance
underwriters. While preserving authority of states to regulate insurance, the Act prohibits state
actions that have the effect of preventing bank-affiliated firms from selling insurance on an equal
basis with other insurance agents. Law creates a new financial holding company under section
4 of the BHCA, authorized to engage in: underwriting and selling insurance and securities,
conducting both commercial and merchant banking, investing in and developing real estate and
other "complimentary activities." There are limits on the kinds of non-financial activities these
new entities may engage in.
Allows national banks to underwrite municipal bonds.
Restricts the disclosure of nonpublic customer information by financial institutions. All financial
institutions must provide customers the opportunity to "opt-out" of the sharing of the customers'
nonpublic information with unaffiliated third parties. The Act imposes criminal penalties on
anyone who obtains customer information from a financial institution under false pretenses.
Prohibits affiliations and acquisitions between commercial firms and unitary thrift institutions.
Makes significant changes in the operation of the Federal Home Loan Bank System, easing
membership requirements and loosening restrictions on the use of FHLB funds.
Dodd Frank-- The Act implemented significant changes affecting the oversight and supervision
of financial institutions and systemically important financial companies. It also provided the FDIC
with new resolution powers for large financial companies, created a new agency (the Consumer
Financial Protection Bureau), introduced (for nonbank financial companies) or codified (for bank
holding companies) more stringent regulatory capital requirements, and set forth significant
changes in the regulation of derivatives, credit ratings, corporate governance, executive
compensation, and the securitization market
7.
Using the effects of the EU Sovereign debt problems, discuss the importance of
regulations mandating a minimum leverage capital ratio for banks.
Leverage ratio measures how much exposure to risk a bank has. These requirements are put
into place to ensure that these institutions do not take on excess leverage and become insolvent
8.

Be able to intelligently discuss the nature and sources of systemic financial risk.

Systemic risk is the possibility than an event at the company level could cause severe instability
or collapse an entire industry or economy. Companies that are considered a systematic sisk are
called too big to fail and make up a significant part of their industry or entire economy.
9.

Be able to discuss key provisions of Dodd Frank, related to regulation of US banks.

Financial Stability Oversight- monitors the performance of companies that are too big to fail
Orderly Liquidation Authority
Volcker Rule- restricts the way banks can invest and regulates trading derivatives
10. What are too big to fail financial institutions. Why are they TBTF? Give several US
examples.

DEFINITION of 'Too Big To Fail'

The idea that a business has become so large and ingrained in the economy that a government
will provide assistance to prevent its failure. "Too big to fail" describes the belief that if an
enormous company fails, it will have a disastrous ripple effect throughout the economy.
Large companies generally do business with many other companies for supplies and services. If
a large company fails, the companies that rely on it for portions of their income might be brought
down as well, not to mention the number jobs that would be eliminated. Therefore, if the cost of
a bailout is less than the cost of the failure to the economy, a government may decide that a
bailout is the most cost-effective solution.
11. Be able to identify the Bank for International Settlements and to describe its importance in
the regulation of financial institutions.
Essentially, the BIS is a central bank for central banks; it does not provide financial services to
individuals or corporations. The BIS is located in Basel, Switzerland, and has representative
offices in Mexico City and Hong Kong. Member banks include the Bank of Canada, the Federal
Reserve Bank and the European Central Bank.
12. Be able to explain how Basel III is likely to result in banks abandoning many of the riskier
businesses in which they have engaged over the past two decades. How did ambiguity of
capital standards encourage banks to engage in these activities.
Basel III is part of the continuous effort made by the Basel Committee on Banking Supervision
to enhance the banking regulatory framework. It builds on the Basel I and Basel II documents,
and seeks to improve the banking sector's ability to deal with financial and economic stress,
improve risk management and strengthen the banks' transparency. A focus of Basel III is to
foster greater resilience at the individual bank level in order to reduce the risk of system wide
13. Be able to explain the CAMELS rating system and its importance as a tool in safety and
soundness regulation for US banks.
C - Capital adequacy
A - Asset quality
M - Management quality
E - Earnings
L - Liquidity
S - Sensitivity to Market Risk
Bank supervisory authorities assign each bank a score on a scale of one (best) to five (worst)
for each factor. If a bank has an average score less than two it is considered to be a high-quality
institution, while banks with scores greater than three are considered to be less-thansatisfactory establishments. The system helps the supervisory authority identify banks that are
in need of attention.
14. In what way is it true that bank regulators sometimes view capital and skilled management
as substitutes for each other?